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CHAPTER 8

CHAPTER 8. CAPITAL BUDGETING. Objectives. At the end of the chapter, you should be able to; Understand the importance of the capital budgeting decision Understand why only cash flows matter Define the types of investment projects Apply the methods used to evaluate capital projects

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CHAPTER 8

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  1. CHAPTER 8 CAPITAL BUDGETING

  2. Objectives • At the end of the chapter, you should be able to; • Understand the importance of the capital budgeting decision • Understand why only cash flows matter • Define the types of investment projects • Apply the methods used to evaluate capital projects • Set out the advantages and disadvantages of each method • Understand why the Internal rate of return may result in a firm choosing the wrong project • Calculate a project’s modified internal rate of return • Understand the relationship of Economic Value Added (EVA) and net present value • Determine the relevant cash flows to be included in the analysis • Include taxation and tax allowances and in the project cash flows • Understand the role of Post-audits in capital budgeting • Use Excel spreadsheets to solve applied Capital Budgeting problems

  3. Outline • Types of Projects • Capital Budgeting Methods • Net Present Value • Internal Rate of Return • Payback and Discounted Payback • Accounting Rate of Return • Profitability Index (PV Index or Benefit-Cost Ratio) • Project Cash Flows • Estimating future cash flows • Taxation • Some rules • Post-Audits

  4. The Balance Sheet (Statement of Financial Position) Why did Wesfarmers invest in these assets? Capital Budgeting

  5. Why is the Capital Budgeting decision so important for the firm? • The Balance Sheet • The Balance Sheet includes past capital budgeting decisions. • Tactical and Strategic Investments • Consequences of Investment and non-investment • Over capacity resulting in high overheads • Under-capacity resulting in loss of market share • High operating costs • Loss of Flexibility - a large investment results in a company losing the option to invest. • Microsoft & Netscape - Microsoft had to change from stand alone systems due to impact of the Internet • Timing • Columbus steel plant • The focus should also be on Project Creation

  6. Replacement decisions Expansion : existing product lines Expansion : new product lines Other (IT, Pollution control, Corporate social investment) Mutually Exclusive vs. Independent Projects Divisible and non-divisible projects TYPES OF INVESTMENT PROJECTS

  7. Why use Cash Flows ? • Future benefits of the project • Only use Cash flows, not earnings • Accounting Earnings vs. Cash Flows • Accounting is based on the Matching Concept • Cost and Depreciation • Taxation - GAAP & Inventory Valuation • Tax is a cash flow and taxable income is based on the Accrual Accounting Model • Accounting does not record opportunity costs; in Capital Budgeting we include cash flows foregone. • Performance Appraisal • Yet if Accounting results are used to measure management performance, then Accounting may be relevant

  8. Corporate Social & Infrastructural Investments • Types of “non-economic” projects • Environment • Human Resources • Small Business • Community Investments • Information Technology • The relevance of DCF techniques • Materiality of Investments • References to Annual Financial Statements

  9. Capital Budgeting Techniques • Net Present Value (NPV) • Internal Rate of Return (IRR) • Payback Period and Discounted Payback • Accounting Rate of Return • Profitability Index (Benefit-cost ratio)

  10. Net Present Value (NPV) • NPV = Future Cash flows discounted at the cost of capital less the Cost of the Project • If NPV > 0, accept the project • If NPV < 0, reject the project

  11. Internal Rate of Return (IRR) • IRR = Discount rate which makes the Present value of the Project’s Future Cash flows equal to the cost of the Project.

  12. NPV ProfileHow will NPV change with a change in the discount rate? IRR

  13. NPV or IRR? • If we analyse the NPV Profile, a project with a positive NPV will also have an IRR to the right of the cost of capital. So the IRR and the NPV methods will give the same answer. Is this always so? • Assume Project A and B are alternative one year investments. A firm can only select either A or B.

  14. NPV or IRR? • Project A results in a higher NPV and Project B results in a higher IRR. Which project should be accepted? • Always select the project with the higher NPV. Why? • The difference in costs should not affect the decision unless the company is subject to capital rationing. If markets are efficient, the company should be able to always raise finance at its cost of capital.

  15. What is wrong with IRR?There could be more than one IRR for non-conventional projects.

  16. Payback Method • Projects are evaluated according to the number of years that it takes to recover the cost of the investment from the cash flows generated by the project. • The firm sets a required payback period, say 3 years. Only projects with payback periods of less than 3 years are accepted.

  17. What are the advantages and disadvantages of Payback? • Advantages • Simple to calculate and understand • Widely used in practice • Risk indicator • Disadvantages • Ignores cash flows after the payback • Ignores time value of money • Bias against long term projects

  18. Discounted Payback • Discounted Payback = time it takes so that the PV of the project’s cash flows equals the cost of the project.

  19. Accounting Rate of Return • Accounting Rate of Return = Net Income/Average book value. • The average book value if the residual value is zero, will be Cost/2 • Net income is after depreciation. • Advantages and disadvantages of ARR

  20. Profitability Index (Benefit-Cost Ratio) • A project’s PI measures the return of a project relative to cost • PI = Present Value/Cost • If PI > 1 = Accept the project • If PI < 1 = Reject the project • As NPV = PV - Cost, a PI greater than 1 means a positive NPV. • When should we use the PI? • If there is capital rationing and we wish to maximise returns relative to the costs of a projects.

  21. Economic Value Added (EVA) • How do we use EVA to evaluate projects? • EVA = Net operating profit after tax - (Invested Capital x Cost of Capital) • Value of Project = Investment + PV of future EVAs • PV of future EVAs = project’s NPV

  22. Cash flows • Estimation of future cash flows • After tax cash flows, therefore need to consider the tax issues • Beginning-of-project cash flows • Cost of project = cash outflow • What about depreciation? • Sale of existing equipment? • Working capital requirements?

  23. Tax Effects - Introduction • Depreciation deduction • Deduction from taxable income • Adjustable Value [undeducted cost] • Cost less depreciation deductions to date • Effect on Cash Flow • Net operating income x (1-tax rate) • Deduction x tax rate

  24. Depreciation Methods • Diminishing Value method =Opening value x 150%/Asset’s effective life • Prime Cost method =Cost x 100%/Asset’s effective life

  25. Balancing Adjustments • Balancing adjustment = selling price – adjustable value If selling price > adjustable value, then this an assessable balancing adjustment. Add to income. If selling price < adjustable value, then the difference is a deductible balancing adjustment. Deduct from taxable income. Capital gains do not apply to depreciating assets – the difference between selling price and the undeducted cost ( adjustable value) is a balancing adjustment.

  26. Depreciation rates for Tax purposes • The ATO has issued recommended effective economic lives for various categories of assets • Effective life = number of years that company can use the asset for a taxable purpose. • Examples: Computers – 4 yrs, forklifts – 11 yrs pumps – 20 yrs, trucks (heavy haulage) – 5 yrs, lathes – 10 yrs • Patent = 20 years

  27. Capital Gains Tax • Companies are subject to Capital Gains Tax on the the disposal of fixed assets. • If the sales price > cost, the difference will be subject to CGT if the asset is NOT a depreciating asset. • CGT = Selling price – base cost. • CGT may apply on the sale of land and other non-depreciating assets. • No inflation indexation, so inflationary gains may be subject to tax.

  28. The effect of depreciation on cash flow • Example: Cost = $800 000. Prime cost depreciation of 20% per year. What is the effect on cash flow?

  29. Relevant revenues & costs - some rules. • Only include Incremental cash flows • Use future after-tax cash flows • Ignore Sunk costs • Opportunity costs - foregone cash flows • Include the negative and positive effects of new product lines on existing lines • Evaluate all alternatives • Ignore all Allocated costs • Ignore Financing charges, as this would amount to double counting. • Working capital • Net incremental • Changes, not levels • Separate accounting from cash flows • Separation of the financing from the investment decision

  30. Working Capital Income Statement Expense Cash out flow

  31. Working Capital

  32. Inventory

  33. Post Audits • What are post audits? • Formal assessment and comparison of actual returns achieved for specific projects as compared to projected returns. • Advantages • Lessons for management. Identify critical factors and ensures focus on achieving projected cash flows • Disadvantages • Sponsors may reduce investments due to personal risks • Difficulties in separation of project cash flows from other business investments

  34. Modified Internal rate of Return (MIRR)

  35. MIRR

  36. Modified Internal Rate of Return (MIRR) • NPV - assumes reinvestment at the cost of capital • IRR - assumes reinvestment at the IRR • MIRR - Assume a reinvestment rate until end of project • MIRR = Rate that causes PV of the terminal value to equal PV of cash outflows

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